Seven Stories in Double - O Seven

Re-acceleration of the US economy

Many economists and US debt traders and foreign exchange traders are pessimistic about the outlook for the US economy. However, the equity market, the narrowness of credit spreads, like corporate bond yields over Treasuries or emerging market debt over Treasuries, would seem to agree with the Federal Reserve and other international officials that the US economy is most likely headed for a soft landing. The risk is that the US economy is not slowing down, it has slowed down. If the economy did not bottom in Q3, it may do so in the current quarter and that next year quarterly growth with average around 3.00%. The one “bet” that has proven wrong time and again is a bet against the US consumer. The doom-and-gloom camp argues that the slump in the housing market will drag down the over-extended consumer. While the economy was admittedly weaker than I thought in recent months, excluding construction and auto sectors and related industries, the rest of the economy appears to be doing well. The key to consumption is income and income measures continue to do well.

Rising tensions with China

China’s growing trade surplus and the dynamics of the US political climate warn that tensions are going to increase. The Chinese yuan has appreciated by about 5.8% against the dollar since July 2005 when it modified its currency regime. The pace of appreciate of almost 4% is likely to be roughly maintained in 2007. There remains the risk that officials sanction a wider band (currently +/- 0.3%), but it does not necessarily mean that a full exploration of a new band would be acceptable at first. Many Republican and Democrat seem frustrated with the failure of the Bush Administration to cite China as a currency market manipulator. Legislation in the New Year to lower the bar to currency misalignment is likely. One can’t help but wonder if we are putting too much emphasis on the currency. Part of the problem lies with US policy makers and media who are doing a poor job preparing and educating Americans on what is really going on. For example, in all the coverage, has there been much attention drawn to the fact that the latest trade data indicates US exports to China rose 27% year-over-year and 66% over the past two years. China is America’s fastest growing export market. But it is not just exports. China is a very profitable market for many US companies? For example, for the beleaguered General Motors, it’s the most profitable market outside the US. Such high profile missions build expectations that the odds would favor disappointment. Even if China were to allow a more rapid appreciation of the RMB—it may not change trade and capital flows significantly. This is not a product of cynicism but rather China is a big importer and a big exporter. The value-added that it contributes to the value of its exports is estimated around 15-20%. That is the fraction of the value of exports that would be impacted by an appreciation of the RMB.

Collapse of the Doha Round

Even before the election, the political tea leaves warned that the Bush Administration’s trade promotion authority would be renewed when it expires in mid-2007. The failure of the Doha round of trade talks at the WTO may prompt some chatter about increased protectionism and in fact that is exactly what John Lipsky, the first deputy managing director at the IMF at argued.. He argued the lack of progress risks backsliding. Talks have broken down over agricultural subsidies. This seems like a scare tactic, because the failure to extend free-trade to new sectors, like agriculture does not necessarily mean that countries are going to question general liberalization in manufactured goods. Rather, the more likely course is that countries continue to pursue more bilateral agreements. Without additional assurances on environmental and labor standards, passage of even new bilateral agreements may be difficult in year ahead.

EM Resilience

Emerging markets have been more resilient than expected. In the past, crises in emerging markets corresponded with tightening cycles by the Federal Reserve. This time has been different. Even the May-June swoon failed to have lasting impact on global investors. Spreads over US Treasuries are finishing 2006 near record lows. Industry reports suggest flows into emerging market equity funds increased markedly in recent weeks. At first, the market’s response to the clumsy effort by Thailand to restrain speculative flows seemed like an eerie repetition of the contagion so clear at the start of the 1997-1998 financial crises, quickly dissipated. In fact, the week in which Thailand imposed its controls, when everything was said and done, the local equity market dropped 7.6%, the MSCI Asia Pacific Index closed up 0.6%, at its best level since May 12. The macro-economic fundamentals in many if not most emerging markets have improved. To the extent that diversification is possible, it seems to lie more in emerging markets or frontier economies, and this coupled with the prospective rates of return attract global asset managers. However, international equity flows to emerging markets is heavily concentrated with some indications that China has been the recipient of nearly half of the EM equity flows. Although Thailand’s move was clumsy at best, the underlying challenge for Thailand and many countries in the region remains. Short-term investment or speculative capital is coming in faster than countries can cope with it. And the only thing worse than the hot money inflows is when it leaves.

Weak Political Leadership

Look at the major industrialized countries. Japan has a new government and won’t have a real mandate until the summer’s Diet election. The Abe government has experienced only a short honeymoon. Canada has a minority government and it appears to be positioning for an election, perhaps in the spring of ’07. Germany has a coalition government and although growth is strong Chancellor Merkel has seen her support wane and the 3% VAT hike will not make her new friends. Italy’s government under Prime Minister Prodi is in a vulnerable position. Although he survived a vote of confidence over the 2007 budget, the opposition is ready to pounce on any disappointment. France will go to the polls in the spring. UK Prime Minister Blair is also expected to step down in the spring. Chancellor of the Exchequer Brown continues to appear to be the odd-on favorite successor. In the US, the Democrats have taken control of both houses of Congress though do not have a veto-proof majority. There is not a clear investment theme from the weakness of political leadership, but it suggests 1) new bold policy initiatives are unlikely to be forthcoming and 2) any crisis might be exacerbated by the weakness at the top.

Distributional Issues

Economies as varied as the US, the UK, China, Japan, Latin America, and many in the Middle East face a similar challenge. Profitability and corporate earnings are strong with many near record levels. The problem is that this is not always trickling down to wages and consumption. To some extent, borrowing has helped households make ends meet in the US and UK. In Japan households have dipped into savings. The growing disparities of wealth ferments dissatisfaction. Sometimes the angst is directed abroad in the form of protectionism. Extreme inequalities may act as a stealth corrosive acid on the social fabric during favorable economic times and becomes more evident and virulent when growth turns lower.

Middle East Woes Intensify

It is difficult to see a favorable outcome. Policy makers must now chose between the least bad course of action. The economic ramifications are modest at best. Early in 2007, President Bush and Congress are likely to fight over how the war is financed with the latter resisting Administration efforts to keep the financing off-budget. Previously it appeared to be in both the Republican and Democrat parties’ interest to depoliticize the issue as it was the debate within the parities was just as intense, if not greater, than the debate between the parties. By the end of 2007, if the situation on the ground has not improved, despite a change in the Administration’s tactics, some pundits expect, the Republican Party elders, fearing an electoral debacle in 2008, force the President to change the strategy not just tactics.